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Derivatives Analysis and Valuation
Derivatives Analysis and Valuation
Theta
Measures how the option premium
changes as expiration approaches
Option Valuation
Terminology
Vega
The sensitivity of the option premium to the price
volatility () of the underlying security
Rho
Measures the sensitivity of the option premium to
changes in interest rates
Gamma
Measures the sensitivity of delta to changes in the
underlying security price
Option-like Securities
Several types of securities contain
embedded options:
Callable and Putable Bonds
Warrants
Convertible Securities
Callable and Putable
Bonds
Callable Bonds contain a “call provision”
The issuer has the option of buying the bonds
back at the call (exercise) price rather than having
to wait until maturity
Attractive option for issuers if interest rates fall,
since they can purchase back old bonds and
refinance (refunding) with new, lower interest
bonds
Typically will trade at no more than the call price,
since call becomes likely at that point
Callable and Putable
Bonds
Putable Bonds contain a “put provision”
Investors may resell the bonds back to the
issuer prior to maturity at the put (exercise)
price, often par value
Puts can generally be exercised only when
designated events take place
Warrants
Warrant is an option to buy a stated
number of shares of common stock at a
specified price at any time during the life
of the warrant
Similar to a call option, but usually with
a much longer life
Issued by the company whose stock the
warrant is for
Warrants
Intrinsic value is the difference between the
market price of the common stock and the
warrant exercise price
Intrinsic Value = (Stock Price – Exercise Price)
x Number of Share
Speculative value is the value of the warrant
above its intrinsic value
Like other options, the value is higher than intrinsic
value, except at maturity
Convertible Securities
Allows the holder to convert one type of
security into a stipulated amount of another
type (usually common stock) at the investor’s
discretion
With convertible securities, value depends
both on the value of the original asset and the
value if conversion takes place
Value cannot fall below the greater of the two
values
Convertible Securities
Convertible Bonds
Advantages to issuing firms
Lower interest rate on debt
Debt represents potential common stock
Advantages to investors
Upside potential of common stock
Downside protection of a bond
Convertible Securities
Convertible bonds
Conversion ratio = number of shares
obtained if converted
Conversion price = Face Value/Number of
shares
Valuation of convertible bonds
Combination value of stock and bond
Two step process to determine minimum
value
Convertible Securities
Convertible Bonds
Value of a convertible as a bond
Determine the bond’s value as if it had no
conversion feature
This is the convertible’s investment value or floor
value
Value of a convertible as stock
Compute the value of the common stock received
on conversion
This is the conversion value
Convertible Securities
Convertible Bonds
Minimum Value = Max (Bond Value,
Conversion Value)
Like other options, including embedded
options, they typically only sell at their
minimum, intrinsic value only at maturity.
Conversion Premium = (Market Price – Minimum
Value)/Minimum Value
Convertible Securities
Convertible Bonds
Conversion Parity Price = Market
Price/Conversion Ratio
An risk-free profit opportunity would exist if the price
of the convertible below this price, since immediate
conversion of the bond and then selling the stock
would yield a profit
Payback
How long it takes the higher-interest income from the
convertible bond (compared to the stock dividend) to
make up for the conversion premium
Convertible Securities
Convertible Preferred Stock
Combination of preferred stock and common
stock
Common characteristics:
Cumulative but not participating dividends
No sinking fund or purchase fund
Fixed conversion rate
Waiting period not required before conversion
Conversion privilege does not expire
Usually issued in connection with mergers
Convertible Securities
Convertible Preferred Stock
Value as preferred stock
Value as common stock, given the
conversion rate
Parity relationships imply that the value
has to be higher than the maximum of
the two values